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Coordinating towards higher values

Real Estate Cycle on Schedule as Manufacturing Falls

by Fred E. Foldvary

The 18-year real estate boom-bust cycle has been running on schedule. The last real estate depression was in 1990, and if the 18-year pattern continues, the next depression will occur around the year 2008. The cycle period has not always been exactly 18 years, so the next recession could come in 2007 or after 2008, but I believe that 2008 is the most likely year.

The latest confirmation of the coming recession has been a drop in manufacturing and construction in the USA. U.S. manufacturing fell for the first time in 3.5 years, while real estate construction had its greatest decline since September 2001. There are already recessions in two key industries, residential real estate and automobile manufacturing. The slow-down in real estate construction causes a decrease in the purchase of related durable goods -- furniture and appliances -- and in turn, inputs such as lumber.

The real estate cycle world-wide follows a consistent pattern. There is first an expansion of money and credit by the monetary authorities. That expansion artificially reduces interest rates, which then increases borrowing for long-duration capital goods such as real estate construction, as well as the purchase of real estate. The expansion of the economy reduces vacancies and then raises rentals and real estate prices. Speculators then jump in to profit from this increase, adding to the demand and accelerating the increase in land values. The expansion of money causes price inflation, so the authorities cut back on the money expansion, raising interest rates.

Higher interest rates and higher prices for real estate then reduce business profits, reducing the rate of increase in investment in new capital goods. Note that at first, investment is still expanding, but it expands at a slower rate. The negative rate of increase eventually makes growth negative also, and output falls. Rising interest rates increases mortgage payments, and as prices and equity no longer increase, those who can barely afford a house or condominium and bought with minimum payment plans have to sell. Rising unemployment also increases foreclosures. Real estate speculators switch to buying foreclosures at below-market rates and flipping them for quick sale to naive buyers who don't understand the real estate cycle.

At first, sales of residential real estate slow down, but owners stubbornly refuse to lower the price, so the inventory of unsold house rises. In California, where house prices have about doubled during the past 5 years, house sales have decreased 29 percent from October 2005 to 2006. Non-residential real estate construction is now also slowing down. While media attention is on residential real estate, commercial real estate is actually more important for the real estate cycle, as business investment in capital goods, including non-residential construction, drives the cycle as high real estate prices and higher interest rates make investment less profitable. We are now seeing a reduction in manufacturing, accompanied by factory shut downs. Non-residential construction fell in October 2006, while residential construction had already been falling.

Of course the data alone do not indicate a coming recession. Economic theory explains the cycle, and data can only be consistent with theory or not. So far, the data is consistent with the pattern of real estate cycles. Some economists and financial analysts say this slow down is only a "rough patch," and the economy will have a "soft landing." But the economy is not an airplane. The pattern is not a descent and landing, but a slow down in the rise, and then a plateau of real estate prices as sales slow down, and a deceleration of output followed by a decline or crash.

Others are predicting a recession already in 2007 because of the reduction in consumer spending from home equity loans. I believe the economy will not fall in 2007, because it takes time for high real estate prices to influence investment, and business investment is still growing. Much of the borrowing from homeowners has been to pay off consumer debt, so the net effect of household borrowing is not really that great, and much of the consumption has been of imports.

Fred Harrison in the U.K. has forecast a depression in 2010, but it seems to me that most likely it will come sooner, as indicated by the recent weakness in the U.S. industrial base. So I am sticking to the 2008 forecast which I have been making for over 10 years. Interestingly, 2008 will be an election year, and a recession would probably deliver the election to the Democratic party.

It is possible that the federal reserve will again lower interest rates or that the federal administration will increase borrowing and spending to postpone the recession into 2009. The U.S. economy has become so politicized that the monetary and fiscal authorities can alter the timing of the next recession, but they are nevertheless powerless to prevent it, as ultimately markets are more powerful than governments. Just as nature strikes back with disease when the laws of nutrition are flouted, the market strikes back with depression when economic policy is arrogant. Since nobody can really predict what the Fed will do a year from now, the exact year of the next depression cannot be forecast precisely, but based on past patterns, one can forecast the most likely year as 2008.

The business cycle is not caused by the private sector, but is a consequence of bad monetary and fiscal policy. Expansion and contractions of money and credit are intended to stimulate the economy when it's down and choke inflation during a boom, but by distorting interest rates and relative prices, they end up destabilizing the economy. Fiscal policy penalizes production and subsidizes land speculation, which combined with credit gyrations, induces speculative real estate booms followed by the decline. So only a radical shift -- to free-market money and tapping land values for public revenue -- will eliminate the cycle. Until this is done, we will just have to ride the economic stream down the next waterfall. You have been forewarned.

This article first appeared in the Progress Report, Reprinted with permission.

Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.